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As economic growth languishes and worries about the specter of deflation mount, much-needed infrastructure development and new sources of project financing could provide a panacea to global growth.

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Taiwan is an economic success story. The island, despite political uncertainty, limited natural resources and a relatively small population, has grown into one of the world’s top 25 economies and the world’s 17th most competitive economy, according to the World Economic Forum’s 2008-2009 Global Competitiveness Index. An Economist Intelligence Unit (EIU) report recently ranked Taiwan as the world’s second most competitive IT market, behind only the United States. Over the past 50 years, Taiwan’s economy has grown at an average rate of 7.7%.

Taiwan’s economic accomplishments stem largely from its success in selling its goods to the world. Because of its small size and limited natural resources, Taiwan relies heavily on exports and, thus, global demand. In fact, Taiwan’s exports account for approximately 70% of total GDP. Because of this heavy dependence, Taiwan’s economy remains tied to the vicissitudes of the global economy and vulnerable to external shocks, such as the current global financial crisis. Taiwan is particularly vulnerable because of its dependence on exports to the US and European Union. In the first 10 months of this year, 11.6% of Taiwan’s exports went directly to the US, and another 10.7% went to the EU. While Asia as a region attracts a much larger portion of Taiwan’s exports, many of those exports serve as components for products that eventually end up on store shelves in the West.

Flagging demand is already having an impact. November exports dropped more than 23% year-on-year. Imports also fell by 13.2%. The disappointing trade performance is already dragging down other aspects of the economy. Taiwan’s third-quarter GDP dropped 1%, the first contraction in more than five years. The domestic stock market has lost over half its value since its peak in May, and industrial production fell 12.6% year-on-year in October.

Following the weak November numbers, the government revised its GDP growth prediction to 2.12% in 2009, and the IMF revised its prediction to 2.5% growth. Fitch Ratings and Swiss bank UBS were more pessimistic. Both predict a recession next year for Taiwan, with the economy contracting more than 1.5%. Kil Dosanjh, a senior economist for the EIU, says slowing exports can create a severe drag on the economy: “Exports and investment are suffering. This will undermine private consumption. More generally, rising corporate bankruptcies and unemployment will raise non-performing loans. A rise in NPLs will further tighten credit conditions, as banks will become increasingly risk-averse.”

Government Steps In
The Taiwanese government has responded quickly, insuring all bank deposits and offering special financing options for small, medium and large enterprises. Since September the central bank has cut policy rates four times and lowered reserve ratio requirements to maintain liquidity. The government also introduced a NT$400 billion ($12 billion) infrastructure investment package and a plan to offer shopping vouchers to its citizens worth another NT$82.9 billion. The central bank estimates that the new package will add 1.64 percentage points to next year’s GDP growth rate.

The government’s moves will help limit the damage but will not be enough to counter the effect of slowing exports, says Sean Yokota, North Asia economist for UBS. “With exports slowing, the government’s hands are tied,” he points out. “They are offering coupons and spending more on infrastructure, but all that adds up to about 2% of GDP. Since exports account for 70% of GDP, a 1% or 2% reduction in exports neutralizes most of the stimulus.”

Dosanjh agrees: “Fiscal stimulus alone cannot offset the large decline stemming from the external sector. Lower interest rates will have a limited impact as firms and consumers face uncertainty, which will limit spending decisions more than the price of funding. Moreover, banks faced with rising NPLs could start to limit financing.” Loan guarantees and a weaker exchange rate could help, Dosanjh believes, but will not counter the effect of slackening export demand.

But there is some good news. Taiwan, which felt deeply the Asian financial crisis in the late 1990s, the bursting of the high-tech bubble, and a credit card crisis in 2005, has been de-leveraging its debt in recent years. The country’s loan-to-deposit ratio is below 80%—among the lowest in the world—and the banking system registered a record low 1.5% non-performing loan ratio in September.

Yokota points out in a recent report to investors that the current account surplus will also help: “Taiwan is running a current account surplus of 7.7% of GDP and is not reliant on capital inflows to support the NTD [new Taiwan dollar] and domestic investment. Yes, the current account surplus will shrink from a slower export environment, but even in the severe recession post the tech bubble, the current account remained positive.”

The Taiwanese government is also making progress on less obvious fronts to strengthen its financial system in the medium and long term. Taiwan, like many Asian countries, has a high savings rate. That high rate does not, however, translate into an equally high investment rate. Part of the reason is the high level of inheritance tax, which prompts many wealthier Taiwanese to move their savings overseas, depriving Taiwanese banks of investment capital.

Taiwan’s cabinet proposed in October to unify inheritance taxes to the drastically lower level of 10%. In December the finance committee of the legislative branch approved the bill, though some exemption-related details remain to be worked out. While the loss in tax revenue will be significant, the resulting increase in domestic investment will soften the impact.

Other proposed regulations, if approved, could further encourage the Taiwanese people to keep their savings in domestic banks. The government is working to attract more experienced wealth management professionals and may give tax breaks to those who relocate to Taiwan. The government is also discussing possible tax breaks for Taiwanese investors who transfer savings from overseas accounts back to Taiwan. Such moves, the government hopes, will help the island’s financial system to eventually rival neighboring financial centers in Hong Kong and Singapore.

Shopper's paradise: Taipei is encouraging people to go out and spend to help the economy.

China Saps Investment
Taiwan’s close economic relationship with mainland China serves as a second factor contributing to the migration of money to foreign markets. Mainland China attracts half of Taiwan’s foreign direct investment, and more than 70,000 Taiwanese companies have operations there. Taiwanese banks are not allowed to operate branches on the mainland, so these companies must manage their mainland operations through overseas financial institutions. Again, however, regulatory and political changes may open up new opportunities for Taiwanese financial institutions.

In March Ma Ying-jeou was elected president of Taiwan on a platform promoting better relations with China. Since he took office in May, a number of measures encouraging more cross-strait economic cooperation have been proposed. Talks between Taiwan and mainland China in November yielded promises to open up direct shipping lines and regular charter flights as well as to improve postal service and food safety standards.

These new moves hold economic benefits that may extend beyond the transportation industry, according to Fitch Ratings’ associate director of Asia sovereign ratings Vincent Ho. “The opening of direct sea and air links may help trade flows between the two places to increase a bit, but I think mainly the service trade sector will benefit significantly because professionals can more easily move between the places. Taiwan in particular can export many such services to China. This will help the service aspect of Taiwan’s economy to grow.”

The opening of transportation links could lead to greater cooperation in other areas, and financial integration may be the next focus for the two governments. Taiwan’s Fubon Bank received permission in November to purchase a 20% stake in China Communications Bank for around $33 million. While the purchase price and stake size are relatively small, the significance is not. The move marks the first such purchase for a Taiwanese bank and could kick off a wave of similar investments. But challenges remain.

Ho’s colleague and head of Fitch’s financial institution team for Taiwan Jonathan Lee explains: “I think this is just the beginning. We expect more of this kind of investment by Taiwanese companies in China. But there is a hurdle. The governments do not have a mutually agreed upon supervisory framework.”

Lee is hopeful, though. “I think the market expectation is, now that transportation links have been opened, that the next move will be to work on a financial supervisory agreement to be signed sometime next year,” he says. “Once that happens, we expect to see more active, aggressive investment by Taiwanese banks in the mainland.”

Such investments hold benefits for companies on both sides of the Taiwan Strait. Taiwanese banks can expand business to cover corporate China and service Taiwanese clients operating on the mainland. Chinese banks can tap Taiwanese banks’ extensive experience and well-developed business and statistical models for areas such as credit cards and mortgage lending. China can also learn from Taiwan’s advanced credit tracking system, Lee points out.

If the governments can reach a supervisory agreement, then many Taiwanese banks may also choose to incorporate independently in mainland China, with a focus on Taiwanese corporate clients. “There are many, many Taiwanese corporations in China,” Lee explains. “So it is good for Taiwanese banks to have a legally functional operation in China so they can further control the credit they give to these corporate clients. That will be their focus.”

The closer relationship between the two powers could be good news for more than just Taiwan and mainland China, according to Andrea Wu, president of the American Chamber of Commerce in Taipei. “Everyone here is very excited about the tightening relationship.”

The challenges facing Taiwan are formidable. The island is integrally connected to global markets and thus cannot escape the turbulence that is unsettling markets around the world. Still, Taiwan’s strong economic fundamentals, its commitment to reform, its increasingly close relationship with China and its naturally industrious people are unlikely to let Taiwan’s economic success story end any time soon.